The Problem with Social Security

The world is facing an unprecedented challenge, says retirement expert William Shipman, Chairman of Carriage Oaks Partners, LLC, and former delegate to the White House Conference on Social Security. Shipman, an advocate of Social Security reform in the United States who has testified before the House Ways and Means Sub-Committee on Social Security, stresses that there are two powerful forces on a collision course that must be kept from colliding: global aging, and failing Social Security systems whose structure renders them “fundamentally flawed.¹” Should these forces meet, there will be “very serious consequences,” he cautions.

To understand the issues surrounding today’s Social Security program, one must understand a little history: First, retirement itself is a relatively new construct, having emerged from the Industrial Revolution in the mid-1800s. For the first time in history, workers reached a point at which they were “too weak to work but not yet weak enough to die.” German Chancellor Bismarck in 1889 introduced the first Social Security system, motivated by the desire to co-opt the idea from the opposing Socialist party. The last powerful nation to adopt the system was the United States, when President Franklin Delano Roosevelt signed it into law on August 14, 1935.

In the United States the Great Depression—not the Industrial Revolution—was the primary catalyst for today’s Social Security system. The current pay-as-you-go system was designed during the Great Depression to be a transfer of wealth from the wealthy (those who had jobs) to the poor (those who did not have jobs). In Shipman’s opinion, this “fundamentally flawed” program has since evolved into the “unsustainable” retirement income system we “enjoy” today.

The world’s 135 Social Security systems, whether practiced in Germany, Chile, or the United States, are financed through a payroll tax. Benefits paid to today’s retirees are financed by taxes from today’s workers; benefits to be paid to today’s workers will be financed by taxes from tomorrow’s workers. It is nothing more and nothing less than the intergenerational transfer of wealth, from the younger workers to older retirees through a payroll tax. There’s no saving, no investing, no capital accumulation, just a transfer.

What once made the American Social Security system effective has brought about its potential for downfall. The amount that can be paid with a payroll tax structure in any year to beneficiaries is the amount of payroll that it has, times the tax rate on that payroll. The amount that can be paid the next year, holding a tax rate constant, can increase by no more than the amount that payroll increases. In the U.S. approximately over the past 50 years, that increase has been a little less than 1.5% in real terms—roughly equivalent to saving and investing for one’s retirement while getting a rate of return of less than 1.5%. According to Shipman, this shows the difference in capital accumulation between a pay-as-you-go system and a market-based system. “In every country that I have looked at where there are data, the return on capital is greater than the real increase of payroll,”¹ he said.

Dissecting the Problem
Shipman believes that “the system is unsustainable as it is presently structured.” He notes that the problems with Social Security are threefold. “First, there’s the increased life expectancy in the wealthier nations, resulting in benefits being paid longer,” he opines. Second, he believes that there’s a decline in the birthrate in wealthy countries, which will result in fewer workers to pay the payroll tax. The end result, Shipman emphasizes, is “as the increased life expectancy meets the lower birthrate, the number of workers shrinks relative to the number of retirees and the ratio begins to wreak havoc with the Social Security system.”¹

The decline in the number of workers to retirees is nothing new. In 1960 in the U.S. there were 16 workers per retiree; today there are three; in 2030 there will be two; and eventually one. “Imagine that we hit one,”¹ said Shipman. The Social Security system today replaces 41% of the average income worker’s last year’s wage. If there were one worker per retiree, the payroll tax rate on that one worker, while holding the replacement rate constant at 41%, would be 41% in order to pay benefits. “You may say, ‘Nobody would be foolish enough to allow that to happen.’ Today in France the payroll tax rate is 51%; in Poland it’s about 45%; in Germany, Italy, Spain, roughly 42%. What we’re facing already exists in Europe. There is now marching in the streets in Paris and in Germany because of this issue of Social Security and not being able to pay benefits,” Shipman says.

Despite the numbers there are many objections to revamping Social Security. Shipman believes that the objections come from simply not understanding the issue, and he underscores his belief that private accounts can be very successful. He notes that Chile’s reformed Social Security program is very successful and now has a 95% participation rate.

According to Shipman, when all is said and done, “Social Security reform will have to occur in some fashion, or run the risk of generating negative cash flow by 2017.”¹ He stresses, “The system needs $10.1 trillion to stay afloat, which today requires $100,000 from each American family.”¹ Needless to say, most would agree that this solution isn’t plausible.

^* Please note that neither William Shipman nor Carriage Oaks Partners, LLC are affiliated with Guardian Life Insurance Company of America or any of its subsidiaries.

¹ 5/25/2005 and 9/15/05 - Presentations on Social Security by William Shipman at TD Waterhouse Institutional Services conference.